Behavioural risk: how to run winners and cut losers

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“Loss aversion is the single biggest reason for failure in our industry and it’s incredible how deeply rooted in our psyche it is,” comments Simon Savage (pictured), risk specialist at GLG Partners, part of Man Group.

The most successful portfolio managers are those who can clearly articulate and express how they make money. If they can’t, logic would suggest that they are merely resorting to a random process.

In an intriguing paper entitled “Fear, overconfidence and irrationality: overcoming the psychological traits that undermine the asset management industry”, published in March 2013, Savage and co-author Paul Gibson, chief tactical writer at Man Group, deliver three key insights related to behavioural risk.

Firstly, many active managers are reluctant to deviate from benchmarks even though maintaining low tracking errors impedes value creation. Managers should, argues Savage, be encouraged to express “real conviction” in their stock picking.

Secondly, too many managers believe in their own talent. This acts as a self-improvement disincentive and creates what Savage refers to as an “entity view”. Not only does this inhibit the ability for managers to self-reflect and build on their strengths while mitigating their weaknesses, it leads to loss aversion: i.e. managers are less willing to make mistakes for fear of tarnishing their reputation. Savage and Gibson argue that managers are more likely to succeed and make better trading decisions by working in a collaborative environment.

“As soon as any hint of loss aversion creeps in you tip the balance towards cutting winners and running losers. And when that happens, you’re baking failure into the cake,” says Savage.

This has led GLG to develop an evaluation framework in which managers are encouraged to hone their skills and develop a growth mindset where their trading ideas are openly shared, and feedback is taken on board.

“You have to understand your strengths and weaknesses and appreciate how you make money – that process-driven approach and building self-awareness is what we at GLG are doing to improve the skill of our portfolio managers as part of an active risk management program.”

“Our aim is to create repeatable, sustainable skill at investing. Fund management is a skill, so what are you doing to improve that skill?

“People at the top of other skill-based professions like elite sport surround themselves with feedback, telling them what they’re good at, and bad at, so they repeat their strengths and omit or improve their weaknesses; that’s how any skill-based activity sustains performance,” says Savage.

Too often, managers focus purely on how much money they’ve made. At GLG, the emphasis is on building the right processes that lead to that end result. Each quarter, Savage meets with portfolio managers to analyse their performance using behavioural reports. “For one portfolio manager, it only took a 50 basis point market reversal to close their winning positions. For losing trades, however, they were willing to wait until the market had moved 5 per cent before closing out: a 10-fold difference in pain threshold.

“For this manager, if they’ve got a winning position and the market moves slightly then do something different. Go for a walk. Talk to a colleague. Alternatively, if it’s a losing position avoid thinking ‘This time it’s different’. Cut the position and expect it to feel bad.

“We’re arming managers with the tools to improve their skills as traders. It’s about eradicating bad behavioural traits and enhancing their core strengths. That’s risk management.”